Equity Valuation

Stocks (Shares)
• Securities to which the right of the shareholders is attached to
participate in the management and profits of the company as
well as to receive a part of its value, if the company is
liquidated.
• Instruments that signify an ownership position (called equity) in
a corporation, and represent a claim on a
proportional share in the corporation's assets and profits (in
general)
• Securities with no maturity.

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 Misconceptions about Valuation
• Myth 1: A valuation is an objective search for “true”
value
– Truth 1.1: All valuations are biased. The only questions are how much and in which
direction.
– Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.
• Myth 2.: A good valuation provides a precise estimate of
value
– Truth 2.1: There are no precise valuations
– Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
• Myth 3: The more quantitative a model, the better the
valuation
– Truth 3.1: One’s understanding of a valuation model is inversely proportional to
the number of inputs required for the model.
– Truth 3.2: Simpler valuation models do much better than complex ones.
 Basis for all valuation approaches
• The use of valuation models in investment decisions
(i.e., in decisions on which assets are under valued or
are over valued) are based upon
– a perception that markets are inefficient and make mistakes in assessing value
– an assumption about how and when these inefficiencies will get corrected

• In an efficient market, the market price is the best

estimate of value. The purpose of any valuation
model is then the justification of this value.
 Discounted Cash Flow Valuation
• What is it: In discounted cash flow valuation, the value of an
asset is the present value of the expected cash flows on the
asset.
• Philosophical Basis: Every asset has an intrinsic value that
can be estimated, based upon its characteristics in terms of
cash flows, growth and risk.
• Information Needed: To use discounted cash flow valuation,
you need
– to estimate the life of the asset
– to estimate the cash flows during the life of the asset
– to estimate the discount rate to apply to these cash flows to get present value
• Market Inefficiency: Markets are assumed to make mistakes
in pricing assets across time, and are assumed to correct
themselves over time, as new information comes out about
assets.
 Discounted Cashflow Valuation: Basis for
Approach
t = n CF
Value =  t
t
t =1 (1+ r)

where CFt is the cash flow in period t, r is the discount rate

appropriate given the riskiness of the cash flow and t is the
life of the asset.
Proposition 1: For an asset to have value, the expected cash
flows have to be positive some time over the life of the
asset.
Proposition 2: Assets that generate cash flows early in their
life will be worth more than assets that generate cash
flows later; the latter may however have greater growth
and higher cash flows to compensate.
 Valuation of the Intrinsic Value of a Stock

Dividend Discount Model

• Finite holding period
• Infinite holding period
Earning Models
• Standard P/E ratio

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 Dividend Discount Model
• An intrinsic value of the stock equals PV of the future income
for shareholders (i.e. dividends paid per a share)
• Analogy to bond valuation; specifications: no maturity, uncertainty of future
dividends, the expected selling price
Finite Holding Period

V0   DIVt t 
T e
P
t 1 ( 1  k) ( 1  k)T
• Pe - the expected selling price
• k – the required rate of interest
• DIVt – expected dividends as at the year’s end

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• Blue Sky is forecasted to pay a $5.00 dividend at the
end of year one and a $5.50 dividend at the end of
year two. At the end of the second year the stock will
be sold for $121. If the discount rate is 15%, what is
the price of the stock?
 5.00 5.50  121
PV  
(1  0.15) (1  0.15)
1 2

PV  $100.00
• Current forecasts are for Blue Sky to pay dividends of
$3, $3.24, and $3.50 over the next three years,
respectively. At the end of three years you anticipate
selling your stock at a market price of $94.48. What
is the price of the stock given a 12% expected
return?
 3.00 3.24 3.50  94.48
PV   
(1  0.12) (1  0.12)
1 2
(1  0.12) 3

PV  $75.00
Dividend Discount Model (Infinite holding period)
• Zero Growth
– D1 = D2 = D3 = D4 = constant
P0 = D/r, where r is the required rate of return (CoE)
• Constant Growth (Gordon Growth Model)
– Dividend grows at a steady rate ‘g’
P0 = D1 / (r – g)
• Supernormal Growth (2 –stage model)
– Dividend steadily grows after t periods
P0 = D1 / (1+r) + D2 / (1+r)2 +….. Dt / (1+r)t + Pt/(1+r)t ,
where Pt = Dt * (1+g) / (r–g)
• H-Model (2 or 3-stage model)
– Earnings growth rate starts at a high initial rate (ga) and
declines linearly over the extraordinary growth period
(which is assumed to last 2H periods) to a stable growth
rate (gn)
 Constant dividend
• Zero Growth: Company A has a policy of paying a
Rs10 per share dividend every year. If this policy is
continued indefinitely, what is the value of a share of
stock if the required rate of return is 20%?

• Example: A stock is selling for Rs200. the next

dividend will be Rs10. You think that dividend will
grow at 10% per year. What return does this stock
offer to you if this is correct?
 Dividend Discount Model

• How to calculate the expected dividend growth (g) – the

maintenance growth model could be used: where RR
means the retention ratio (retained profit/total profit)
• P0 = D1 / (r – g)= D0 (1+g)/ (r – kb)

EPS e 1  RR 
P0 
k  ROE  RR 

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 DDM Examples
1. (a)Constant Growth model: A stock pays dividend of
Rs. 4 per share. This dividend is expected to grow at
a rate of 8% every year. The required rate of return
is 13%. What is the price of the stock now? What
will be the price of the stock 5 years from now?
(b)What will be the value of the stock if it is not paying
dividend now and it is expected that the first dividend
of Rs4 will be paid in 5 years and then it will grow at 8%
indefinitely
 TWO STAGE MODEL

• It is a form of DCF method.

• Assumption :
– First stage goes through extraordinary growth phase
– Second stage goes through a constant growth phase
– Constant DPO and cost of equity
 The Two-Stage Growth Model

D0 1  g1  D0 1  g1  1  g 2 
T t T
V0   
t 1 ( 1  k)t
( 1  k)T
k  g 2 
• For companies in the growth phase
• In the first phase there is a constant dividend growth (g1)
• In the second phase there is a lower constant dividend growth
(g2)

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 Example 2
• Analysts predict that in coming 4 years dividends paid by
Microsoft are going to rise by 15% because of attractive
investment possibility of the firm. Regarding the
systematic risk, investors require a 16% rate of return.
After 4 years a 5% dividend growth of Microsoft’s shares
is expected (this year Microsoft paid a USD 4 dividend).
Microsoft’s shares are now traded at USD 46 on the
NYSE. Calculate if the share is fair valued in the market.

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 H-Model
• During the horizon period, firms have higher growth rate.
• After some years, there is constant decline in the growth rate.
• The dividend discount model formula is extremely sensitive to
assumptions regarding growth rates.
• Therefore, to overcome this limitation, “H Model” was
created.
 H Model
H-Model Illustration
 Example: Two-Stage H-Model

A new firm has seen a constant decline in its growth

rate. It was 20% and is stabilised at 6% in a gap of 10
years. The required rate of return is 10% after 10 years.
The dividend paid is $3. Current market price of the
stock is $120. Find that the current stock is whether
over-valued or under-valued.
Example: Two-Stage H-Model

Current dividend $3.00

Extra ordinary growth rate(gA) 20%
Normal growth rate(gN) 6%

Number of constant declining

years (N) 10

Required return on stock (r) 10%

Current stock price $120
Example: Two-Stage H-Model

 D0  1  gNL     D0  H  g SA  g LN  
V0 
r  g LN

$3  1  0.06    $3  5  0.20  0.06  

V0 
0.10  0.06
V0  $79.50  $52.50  $132.00
 DDM Examples
5. H-Model: Company paid dividends per share of Rs.5 on reported
earnings per share of Rs10 last year. The firm’s earnings per share
have grown at 15% over the prior 5 years but that growth rate is
expected to decline linearly over the next 5 years to 7%, while the
payout ratio remains unchanged. The beta for the stock is 0.9,
riskfree rate is 7.5% and the market risk premium is 8%

DPS 5 Beta 0.9

EPS 10 Rf 7.50%
Payout Ratio 50% MRP 8%
ga 15%
gn 7%
H 2.5

Cost of Equity 14.7%

Value of Stable Growth 69.5

Value of supernormal growth 13.0
Value of Stock 82.5
 DDM
• 3-Stage DDM Model
– Combines the features of the two stage model and the H-model
– Assumes an initial stage high growth period, a second period of
declining growth and a third period of low stable growth that lasts
forever
 Earning Models
• Often used in the mature markets
• Based on P/E ratio (the stock market price/earnings
per share)
• P/E ratio positively influenced by growth market
opportunities and negatively influenced
by the required rate of interest (k) that is above all
positively influenced by inflation rate

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 Price multiple models

Price
Multiple
Model

Price Price multiple

multiple based on
based on fundamentals
comparable
 Price Multiple Model
• In price multiple based on comparable, the price multiple
is calculated based on the actual market price of the stock
and is compared to a benchmark to evaluate whether the
stock is undervalued, overvalued or fairly valued.
• When using price multiples based on fundamentals, the
price multiple is calculated based on the forecasted value
of the stock calculated using a valuation model such as
DDM.
• In this method, an analyst will first calculate the fair value
of a stock using a valuation model.
• Then he will divide this fair value with one of the stock’s
fundamental such as earnings, sales, book value, or cash
flow to arrive at the price multiple.
 Earning Models (2/2)

Standard P/E Ratio

• comes from DDM

V0  E1  P / E N

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 Example 4
• Metrostav’s shares are priced at Rs 120 today on PSE.
Analysts expect a Rs 12 EPS. P/E ratio amounts 15.
Decide if Metrostav’s stocks are undervalued or
overvalued on PSE.

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 Guidelines for selecting the model
• Gordon growth model is suitable for firms that are
fairly stable and mature, pay regular dividends.
• Multistage dividend model is used for companies
that experience an exorbitant growth rate for a few
years which is then reduced to a constant growth in
the future.
• For companies that do not pay dividends, Free cash
flow to equity is the appropriate model.
• Price multiplier model can be used in case to
compare the value to the peers in the industry.
 Stock Price and Earnings Per Share
Example
Our company pays a $8.33 dividend every
year, which represents 100% of its earnings.
This will provide investors with a 15%
expected return. Instead, we decide to retain
40% of the earnings at the firm’s current
return on equity of 25%. What is the value of
the stock before and after the earnings
distribution decision?
• Pay a $8.33 dividend next year, which represents 100% of its
earnings. a 15% expected return.
• Plowback 40% of the earnings at the firm’s current return on
equity of 25%.
The value of the stock with and without growth:

No Growth With Growth

P0 
8.33
 $55.56 g  0.25  0.40  0.10
0.15
5.00
P0  *1.10  $110.00
0.15  0.10
 Example 1
• Calculate the intrinsic value of a stock, if you require
16% rate of return and assume that after 3 years you
will be able to sell the stock for Rs 2,000. At present
the company has just paid a dividend of Rs 120 per
share. It is assumed that its future dividend growth
will be at 6%.

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 DDM Examples
3. Supernormal growth model.
Company Fast-track has been growing at a phenomenal rate of
30% every year due to its rapid expansion and sales. You think
that this growth rate will last for another 3 years and then the
rate will drop to 10% per annum. If the growth rate remains at
this rate indefinitely, what is the value of the stocks? Dividends
paid was Rs.2.50 and the required rate of return is 20%.